When debts surpass their means, be ready with wise counsel.

Tax
and financial advisers should be prepared to discuss a range of
possibilities for their clients who are facing financial
difficulties and help make the best choices given their
circumstances and goals. Should they consider bankruptcy? If they
want to avoid bankruptcy, how can they best reduce their debt? Which
actions should clients avoid? Which actions should professionals
handle? This article highlights some nonbankruptcy options for debt
reduction and the related tax consequences and identifies actions to
avoid that could cause legal difficulties if the client ultimately
files bankruptcy.

NONBANKRUPTCY OPTIONS FOR DEBT REDUCTION

A
client can take certain actions to try to settle debts without
filing bankruptcy.

Debt
negotiations. Any
debt, whether evidenced by a formal loan agreement or not, can be
negotiated. A client may be able to negotiate a settlement with a
creditor (for example, a hospital) for less than the balance due.
However, if the agreed-upon balance is not paid, the account may be
turned over to a collection agency.

Clients
who want to negotiate a settlement with a credit card company should
be cautious. If clients use a debt management agency, they should
first check with the Better Business Bureau, the National Consumer
Law Center or the Consumer Federation of America to ensure the
agency’s reliability. Reputable agencies and attorneys who handle
credit card negotiations charge a fee for negotiating a certain
number of cards, plus a deposit of up to 50% of the unpaid balance
on the cards. Once a settlement is reached, the deposit is used to
pay the negotiated debt balance. If the credit cards are settled
successfully but the client has others that are unpaid, the client
should wait at least 90 days before filing bankruptcy on the
remaining debts to avoid preference challenges (discussed later in
this article).

For
debts that are evidenced by a formal loan document, negotiation
strategies include extension and modification agreements. Extensions
involve a change in the payment schedule itself. One common practice
involves extending the term of the loan by tacking past-due payments
on to the end of the loan. For example, if three $500 monthly
payments are not made on a 15-month loan, the three $500 payments
would be moved to the end of the loan, extending the term of the
loan to 18 months. Interest would typically continue to accrue
daily, increasing the total amount paid over the life of the loan.
In contrast, loan modifications change the terms of the agreement,
such as principal amount, interest rate or length of the loan,
resulting in a lower payment amount. The lender might in return
require a “balloon” payment at the end of the original term.

In
conjunction with an extension or modification agreement, the lender
might try to improve its position by requiring the client to provide
new or additional collateral and/or a personal guarantee of the debt.

Surprisingly,
there might be times when a lender offers to release collateral when
a loan is in trouble. This could occur when the client is
contemplating filing a Chapter 13 repayment plan bankruptcy and the
value of the primary residence is less than the mortgage. In a
Chapter 13 case, mortgages on the primary residence generally cannot
be modified in bankruptcy without the lender’s consent, unless the
loan is cross-secured with other real property or personal property
(for example, a car). If the mortgage is secured by the primary
residence and other property, the mortgage could be reduced to the
value of the primary residence (called a “cram down”). The lender
might offer to release the additional collateral to avoid this
involuntary loan reduction.

For
example, assume the client’s home has a fair market value of
$100,000, the client’s car has a fair market value of $5,000, the
current mortgage balance is $150,000, and both the home and the car
are collateral for the mortgage. In a Chapter 13 proceeding, the
bankruptcy court could reduce the mortgage to the home value of
$100,000. If the car was released as collateral prior to the
bankruptcy proceeding, the mortgage balance of $150,000 could not be
modified without the lender’s consent. If the lender offers to
release collateral, clients should consult with bankruptcy counsel
to avoid giving up valuable rights in a Chapter 13 bankruptcy.

Tax
consequences. Successful
debt negotiations can have tax consequences. Generally, full or
partial forgiveness of debt is taxable cancellation of debt (COD)
income under IRC § 61(a)(12). Even if principal is not reduced,
significant modifications in the terms of a loan can trigger an
exchange that results in COD income (Treas. Reg. § 1.1001-3(b)). The
modified debt is treated as new debt. Under IRC § 108(e)(10), the
taxpayer recognizes COD income equal to the excess of the issue
price of the new debt over the amount of the original debt. Release
of collateral generally is considered a significant modification for
nonrecourse debt; for recourse debt, release of collateral is
significant only if it results in a change in payment expectations
(Treas. Reg. § 1.1001-3(e)(4)(iv)).

IRC
§ 108(a) provides for specific exceptions to income recognition from
debt forgiveness. For example, a taxpayer who is insolvent
immediately prior to the debt forgiveness may exclude COD income up
to the amount of the insolvency. However, section 108(b) requires a
reduction in the taxpayer’s tax attributes for the amount of
excluded income. Homeowners are entitled to exclude income from the
release of acquisition indebtedness on a qualified principal
residence occurring before Jan. 1, 2013. Per section 108(h)(1), the
basis of the residence must be reduced by any amount of the
discharged debt that is excluded from gross income.

FORECLOSURE

If
the client is in default on his or her mortgage, the lender could
file a foreclosure suit with the court. The court enters a judgment
of foreclosure and sets a sale date. The property is usually sold at
public auction, and the lender has the right to bid in the amount of
its mortgage. After the judgment of foreclosure is entered, the
client has a right to redeem the property by paying the full amount
owed. The redemption period varies by state and can range from one
to 12 months after the judgment of foreclosure is entered. The high
bidder receives a certificate of sale, which entitles him or her to
the property if it is not redeemed. The lender can sue the client
for any deficiency balance.

A
lender may suggest a “deed in lieu of foreclosure” instead of going
through the more time-consuming judicial foreclosure, which could
last six months or more. The lender receives title to the property
in exchange for canceling the debt. The debtor loses any right to
redeem, or reacquire, the property. While simpler and cheaper for
the lender, a deed in lieu of foreclosure requires the client to
move out of the home sooner. This option might be advisable if the
property is worth much less than the mortgage balance. However, the
client should seek the advice of legal counsel before agreeing to a
deed in lieu of foreclosure.

The
client can challenge the foreclosure procedure in court. Certain
technical foreclosure defenses could delay the foreclosure. Although
ultimately the client would lose the house, these defenses might
enable the client to remain in the house without making mortgage
payments for 12 months or more. The client should consult with an
attorney experienced in foreclosure defense.

For
tax purposes, foreclosure is treated as a sale where the amount
realized includes the debt canceled (Treas. Reg. § 1.1001-2(a)). No
COD income will be recognized when property is secured by
nonrecourse debt. The full amount of the debt canceled is included
in the amount realized on the sale of the property without regard to
the property’s fair market value. When property is secured by
recourse debt, the foreclosure is treated as two separate
transactions. The amount realized on the deemed sale of the property
equals the property’s fair market value. The COD income equals the
amount of debt canceled in excess of the property’s fair market value.

ACTIONS THE CLIENT SHOULD AVOID

Many
financially distressed clients try to resolve their debts in hopes
of avoiding bankruptcy, but financial advisers should warn them
about a number of risky pre-bankruptcy actions.

The
collection process. The
client should understand that certain actions might facilitate the
creditor’s collection efforts prior to filing bankruptcy.

Contacting
creditors. Clients
should not contact creditors who have not contacted them. Don’t
wake the sleeping baby!

Threatening
bankruptcy. Clients
should not tell a creditor they are considering bankruptcy
unless they have hired a bankruptcy attorney. The creditor might
rush to obtain a judgment against the client before bankruptcy
prohibits further collection.

Maintaining
bank balances. Clients
risk losing money in their bank accounts. Creditors can seize it
or ask the bank to freeze the account. Banks can offset money in
the account against a debt owed to the bank without court
approval. Clients should promptly pay their normal monthly bills
and avoid carrying large balances. They might consider keeping
money in the form of cash or money orders.

Ignoring
lawsuits. Once
a creditor files a lawsuit, clients must appear in court and
object to the debt. If they fail to do so, the creditor can
obtain a default judgment and promptly start wage garnishments
or freeze bank accounts and/or put liens on the client’s property.

Potentially
fraudulent transactions. Debts
might become nondischargeable and/or property could be recovered by
the court in a bankruptcy or state court proceeding if the client
engages in any of these activities:

Transferring
property with the actual intent to keep it out of creditor’s
hands. The
client also could be subject to criminal prosecution for
committing intentional fraud.

Disposing
of assets at less than fair market value within four years of
bankruptcy. Even
if the client does not intend to hide assets from creditors,
such a transfer can be treated as “constructive fraud.” For
example, selling property at a price less than what would be
received in an arm’s-length transaction or paying a family
member’s bills fit under the constructive fraud
umbrella.

Increasing
debt through borrowing, balance transfers on credit cards or
loan consolidations. Creditors
argue that engaging in these transactions too close to filing
bankruptcy, knowing repayment is unlikely, is a fraud on the
creditor extending the new credit.

Making
contributions to a 401(k) in excess of the normal amount
deducted from each paycheck. Although
a certain amount of pre-bankruptcy planning is allowed, trying
to convert assets into “exempt” assets is risky and could be
interpreted as intent to defraud creditors.

Exempt
property. Exempt
property cannot be attached or levied upon by creditors. Exempt
property includes Social Security, disability, unemployment,
workers’ compensation and pension benefits. A client should preserve
exempt property by avoiding the following actions:

Paying
unsecured debts with exempt property. The
client should not waste exempt property by paying unsecured
debts (such as credit cards and medical bills) that normally
would be discharged in bankruptcy.

Moving
out of the home. Moving
out of the residence could result in loss of the homestead
exemption, which protects part of the owner’s
equity.

“Borrowing”
from qualified retirement accounts. Pensions,
IRAs, 401(k)s and other qualified retirement plans are exempt
and should not be used to pay creditors. There also can be
negative tax consequences. IRC § 72(t) requires early
distributions from a qualified retirement plan to be included in
gross income and subjects them to an additional tax equal to 10%
of the amount of the distribution. As detailed in section 72(p),
certain actions could cause loans from a plan to be treated as
distributions. For example, the outstanding balance of a loan
will be treated as a distribution if the taxpayer defaults.
Also, loan amounts that exceed certain thresholds and loans with
a repayment period greater than five years are treated as
distributions. The five-year rule will not apply when the loan
proceeds are used to purchase a principal residence.

“Preference”
payments. Preference
payments are made to select unsecured creditors prior to bankruptcy,
enabling them to receive more than other unsecured creditors would
receive. The bankruptcy court can recover these payments from the
debtor or the recipient. Preference payments are not fraudulent and
would not result in nondischargeable debt. Two primary examples of
preference payments are payments to relatives or friends within one
year prior to filing bankruptcy and payment to an unsecured creditor
of more than $600 within 90 days prior to filing bankruptcy, unless
the payment is in the normal course of business.

Divorce
issues. Support
payments and property settlements present extremely complex issues.
If a client is considering both divorce and bankruptcy, advice of
competent counsel in each of these areas is essential.

BANKRUPTCY AS THE LAST RESORT

A
bankruptcy negatively affects a client’s credit rating and will
usually make it more difficult to obtain credit in the future.
Therefore, it should be considered as a last resort, not as the
first solution to resolving credit problems. Competent bankruptcy
counsel should be consulted if a client is seriously considering
filing bankruptcy.

LAYING OUT THE OPTIONS

CPA
tax and financial advisers play a vital role in counseling the
financially distressed client. Advice can focus on what affirmative
actions are available to the client and the tax consequences of
various options. Of equal importance, however, is recognizing what
actions could have severe consequences if the client ultimately
files bankruptcy. If it appears to the financial adviser that a
bankruptcy is likely, always advise the client to consult legal counsel.

EXECUTIVE SUMMARY

CPA advisers can help clients in financial straits avoid
bankruptcy or avoid missteps that could further cloud already
bleak finances.

Debt settlement negotiations with credit card companies should
be done with caution. Any debt management agency engaged should
have a good record for reliability. If a home mortgage lender
offers to release other property held as collateral, clients
should consult an attorney to avoid giving up valuable rights in
a subsequent Chapter 13 bankruptcy.

Various types of debt modifications can result in taxable
income to
the debtor from cancellation of debt. Some types of debt
forgiveness are excluded from income, but they are not without
potential costs to the taxpayer. The insolvency exclusion, for
example, requires a corresponding reduction of tax attributes,
and one for qualified principal residence indebtedness reduces
the home’s basis.

A
“deed in lieu of foreclosure” that
gives title to the mortgage holder in exchange for canceling the
debt may be preferable to foreclosure if the amount owed far
exceeds the property’s value.

Debtors facing a collection action sometimes
inadvertently facilitate the creditor’s collection efforts. They
can take some actions to preserve property as exempt from a
bankruptcy estate. On the other hand, such actions as disposing
of or transferring property could run the risk of recovery by a
court and could result in corresponding debts becoming
nondischargeable.

For
more information or to make a purchase, go to cpa2biz.comor call the Institute at 888-777-7077.

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